Japanese economy grew at 3.5 percent pace in 1Q

People are reflected on an electronic board of a securities firm in Tokyo, Thursday, May 16, 2013. The benchmark Nikkei 225 stock index rose to 15,139.56 early Thursday before falling back slightly on profit taking. It has gained about 75 percent since November in a rally linked to high hopes for Primer Minister Shinzo Abe's policies, which have been dubbed "Abenomics." Japan's economy enjoyed a stronger than expected recovery last quarter, growing at a 3.5 percent annual pace as the government stepped up public works spending and eased credit to encourage investment. (AP Photo/Koji Sasahara)

TOKYO (AP) -- Japan's economy grew by a stronger-than-expected 3.5 percent in annual terms last quarter, giving Prime Minister Shinzo Abe a boost as his government tackles reforms needed to ensure a sustained recovery from two decades of malaise.

Stronger consumer spending and public works investment coupled with aggressive monetary easing lent oomph to the recovery that began in the last quarter of 2012, when annual growth was 0.3 percent.

The preliminary data for January to March showed the world's third-largest economy grew 0.9 percent on a quarterly basis, the fastest pace in a year, according to figures reported by the Cabinet Office on Thursday.

Abe took office in late December after voters fed up with years of economic misery returned his Liberal Democratic Party to power. His policies have helped push share prices to their highest levels in over five years, fueled by strong liquidity and expectations of improved profitability for listed companies.

But the real test will be whether the gains can be sustained in the longer run, said Masamichi Adachi, an economist with JP Morgan in Tokyo.

"It's not what we can see from just one quarter's growth," he said.

Demand has been "front-loaded" by a sharp increase in public works contracts and by household purchases being made now to beat sales tax increases in 2014 and 2015. Keeping growth at the 3 percent or 4 percent pace needed to counter deflation and tax hikes expected next year is a "mission impossible," Adachi said. "The sustainability beyond next year, we just don't know."

The benchmark Nikkei 225 stock index slipped 0.4 percent Thursday to close at 15,037.24, falling back on profit taking. But it has gained nearly 75 percent since November in a rally linked to high hopes for Abe's policies.

"Japan's healthy-looking GDP data are the first substantial piece of good economic news under the Abe government," said Julian Jessop, an economist with Capital Economics in London.

He said it was unclear how much of the rebound could be attributed to Abe's policy blend, dubbed "Abenomics," but that "the government can at least claim some credit for boosting confidence in the economy."

The improvement makes it more likely the government will be able push ahead with its pledges to raise sales taxes over the next two years to help improve Japan's deteriorating fiscal health, said economy minister Akira Amari.

Japan's public debt is more than twice the size of the economy and still growing as the government struggles to revamp aging infrastructure, rebuild from the March 2011 tsunami and meet the social welfare needs of its increasingly elderly and shrinking population.

However, top government spokesman, Yoshihide Suga, said the decision on raising taxes would hinge on how the economy performs over the coming months.

"Consumer sentiment seems to have recovered," Suga told reporters. "But at this point we should not be overly optimistic."

"The Abe administration's policies are starting to see some results, but we need to achieve economic growth with employment and we will work to achieve this."

Apart from soaring share prices, Japan's manufacturing and employment showed slight improvements in March, buttressing hopes that the economy may be headed for a moderate recovery. The government on Thursday raised its estimate for industrial production in March, saying it rose 0.9 percent rather than the earlier-reported 0.2 percent.

A sharp decline in the value of the Japanese yen, brought on by monetary easing and by expectations of further easing, has helped some exporters and provided a windfall in yen terms for companies repatriating overseas earnings. But it is also raising costs for many companies that depend heavily on imports of natural gas and other commodities.

Exports rose 3.8 percent in the first quarter, the first such increase in a year, while consumer spending, which accounts for a hefty 60 percent of total business activity in Japan, climbed 0.9 percent as households bought more cars and other durable goods.

The central bank, which is committed to 2 percent inflation within two years, says it expects a moderate recovery by midyear but has warned that uncertainties in the domestic and global economies could foil those hopes.

Abe needs fast results as ammunition in an election for the upper house of parliament in July, a vote that will determine his Liberal Democratic Party's chances for pushing through with other policy priorities, such as revision of Japan's war-renouncing constitution.

Critics of the Abenomics strategy question whether the extra funding pumped into the economy will foster sustainable growth or just push up prices for shares and other assets.

Key to the success of the policies will be increased spending by households and corporations, partly due to expectations that prices will rise. So far, increases in spending have been attributed mainly to luxury purchases by share investors splashing out after seeing gains in their portfolios.

The first quarter data showed no pickup in corporate investment or in prices.

Analysts had generally forecast a 2.7 percent to 2.8 percent increase in GDP in January-March and quarterly growth of about 0.7 percent.

Much of the growth in the first quarter of the year came from public demand: government spending on reconstruction from Japan's March 2011 tsunami disaster and other public works. Private demand has been fueled by a recovery in housing investment, which has picked up sharply as purchasers rush to beat the expected increases in sales taxes.

The sales tax increase, while needed to help reduce Japan's massive public debt, will amount to a "major fiscal tightening," said Jessop.

To keep growth on track, the government will have to carry out fiscal and structural reforms — such as changes in labor, education and tax policies and administrative deregulation — to help improve Japan's long-term competitiveness and adapt to its aging and shrinking population.

In the near term, if companies do not boost wages to help improve household purchasing power, inflationary policies could just discourage consumer spending.

Data released Wednesday showed consumer confidence fell slightly in April, though it has improved since late last year.